In the words of Benjamin Franklin (1706-90), one of the Founding Fathers of the United States, "In this world nothing can be said to be certain, except death and taxes."
Given that most people do not like to dwell on these subjects it is little wonder that inheritance tax, which encompasses both eventualities, is so unpopular.
The History of Inheritance Tax in the UK
Inheritance tax dates back to 1796, when it was called legacy, estate and succession duties. The original aim was to impose taxes on wealthy estates and redistribute the proceeds to the poor. It was renamed death duties in 1894, capital transfer tax in 1975, and finally inheritance tax (IHT) in 1986 and has certainly played a part in breaking up large estates.
What is inheritance tax and what rate is it paid at?
Contrary to widespread belief IHT does not just affect the very wealthy; it will apply to anyone with an estate worth more than £325,000 if they are single or divorced, or £650,000 for those who are married or in a civil partnership. These thresholds are also known as the Nil Rate Bands (NRBs) below which no tax is due. Since 2007, when a spouse or civil partner dies any unused tax free allowance will be transferred to the survivor thus doubling the allowance if they inherit the entire estate.
It is important to remember that your estate comprises all
your assets including property, land, savings and investments, holiday homes, house contents, cars, jewellery and art to name a few. For most people, property is likely to be their largest asset. According to Land Registry figures for March 2016 the average property price in England and Wales was nearly £190,000 while in London prices reached nearly £535,000, well above a single person’s IHT threshold even before considering the rest of their estate.
If your estate is worth more than the applicable threshold, anything over this amount, which is not left to a spouse or civil partner, will be taxed at 40%
upon your death.
Mr Smith dies and leaves his assets to his wife. As estates left to a spouse are tax free there is no tax to pay and Mr Smiths Nil Rate Band (NRB) of £325,000 transfers to his widow. On the subsequent death of his wife the estate will therefore have a NRB of £650,000.
If the total value of the estate is £775,000, comprising property valued at £450,000 and investments of £325,000, inheritance tax is payable on £775,000 less £650,000 i.e. £125,000. A tax rate of 40% will therefore result in a tax bill of £50,000 for Mrs Smith’s beneficiaries.
So what is changing?
It was announced in the July 2015 Budget that from 2017
, a new ‘main residence’ allowance of £175,000 will be phased in to help more people to leave their home tax free to their immediate family*. Immediate family includes children, stepchildren, adopted and foster children and grandchildren. Couples without children to inherit their assets will unfortunately not benefit from this new allowance which has lead to lobbying of the Government to widen the definition of family.
As the new allowance is in addition to the existing £325,000 NRB a couple will be able to leave £1 million to their children without paying inheritance tax by 2020. This extra relief is per person and can be transferred to your partner when you die.
It will be phased in as follows:
||Main residence allowance
The nil rate tax band covers homes valued at up to £2m. Beyond this it will be tapered away at the rate of £1 for every £2 the value of the estate exceeds £2m. It does not extend to second properties or buy to let properties.
Why do I need to think about making plans?
Inheritance tax has affected a growing number of people over the last 20 years as house price inflation has far exceeded the rise in the NRB and despite the increased allowance it is set to affect more people. The number of Britons paying it will rise considerably over the next five years according to official statistics published alongside the Budget. Inheritance tax paid to the government in the tax year 2015/16 is estimated at over £4bn from 40,000 estates, rising to around £6bn from 60,000 estates by 2020/21.
The allowance of £1m sounds very generous but when you add up all your assets and factor in future inflation, particularly of house prices, the importance of taking steps to reduce a possible charge becomes clear. The Centre for Economics and Business Research forecasts average UK property prices to reach £321,000 by 2020 and be considerably higher in the South East and London.
Moreover, the Nil Rate Band has been frozen for the next four years meaning it will effectively reduce because of inflation.
To ensure your estate is distributed in accordance with your wishes it is imperative to write a Will and then amend it if your circumstances change. The Law Society estimates that one third of people do not get round to writing a Will. Failure to do this can cause additional worries for the bereaved family at an already difficult time.
When no Will exists the rules of intestacy apply: under these rules partners receive personal belongings and the first £250,000 of the estate plus half of the remainder with the other half divided between surviving children. Unmarried partners do not have any rights.
What steps can I take to minimise any future liability?
If you have a potential IHT liability, the good news is that there are a number of options available to help reduce or even eliminate it. However, many of these solutions require several years to become fully effective, so it is vital that you start your IHT planning early. We outline a few of them below.
- You can make unlimited gifts of any amount but it is important to act early because of the 7 year rule. What’s the 7 year rule? Well this basically means that gifts which are made outside the nil rate bands will be counted as part of your estate if you die within 7 years although this is tapered as follows:
|Years between gift and death
||% of full 40% IHT payable
Two further significant changes to the inheritance rules: Pensions freedom & passing on your ISA
Bequeathing your pension pot
- Making gifts can be a way of keeping your assets under the NRB and there are also some useful concessions. Up to £3,000 per annum can be given to one or more individuals without any IHT liability and unlimited small gifts of up to £250 are permitted but not to the same people as the £3,000. Wedding gifts of up to £5,000 from a parent to the bride and groom can also be made.
- Trusts are another way to manage inheritance tax liability. There are a number of strategies and these can be quite complex. Furthermore, there are drawbacks such as giving up ownership, access to and control of your assets. Again, it takes up to 7 years for assets to fully pass outside your estate. If you have substantial assets it may be worth contacting an expert tax advisor for more details of these vehicles.
- Gifts to charities during your lifetime or in your Will are IHT exempt. If you decide to leave at least 10% of your taxable assets to good causes the rate of IHT on the remainder of your estate is reduced from 40 to 36%.
- Some specialist investments which can reduce tax liability after an initial period include: AIM portfolio schemes, Seed Enterprise Investment schemes and EIS schemes. These are aimed at investors with significant assets and knowledge and tend to involve a higher level of risk. AIM shares are usually less liquid than shares listed on the main stock exchange but have the advantage of being eligible for inclusion in an ISA thus avoiding both income and CGT.
- There are further complex schemes such as establishing private companies to invest in business relief qualifying companies such as land and property, renewable energy and financing which are outside the remit of this article.
- Life insurance products are available which have been designed to cover the cost of inheritance tax- if written in trust they remain outside an estate.
- Finally, holding the family home as ‘tenants in common’ might avoid having to sell it to fund care fees but specialist advice should be sought.
The government has removed the punitive tax of 55% on a pension fund** which is part of an estate. The 55% tax charge was reduced to 45% in April 2015 and from April 2016, for the majority of people, pension pots will be taxed at the beneficiary’s marginal rate of income tax. However, the tax free Lifetime Allowance (before punitive tax rates are applied) on total pension pots will be reduced to £1m from April 2016.
The new rules allow pensions to be passed down in the following way (from April 2016):
Bequeathing your ISA
||Before age 75 years
||After 75 years
||Taxed at beneficiary’s marginal rate
||Tax free from annuity or drawdown
||Taxed as income from annuity/drawdown
From April 2016 ISA tax benefits can be inherited by spouse or civil partner. Previously the investments within an ISA became subject to income tax and capital gains tax on the death of the holder. Now the surviving partner will receive the tax advantage as a one off adjustment to their own allowance. On the second death they form part of an estate when calculating inheritance tax so there may be a case for drawing income from ISAs before pension funds since the latter falls outside your estate for the purpose of assessment of inheritance tax. Furthermore, pension fund withdrawals are subject to income tax, unlike ISAs.
Following these radical changes to the inheritance tax regime there are unlikely to be further significant changes in the short term so if you think you could be one of the people likely to fall in to the IHT net then it may be worth carefully considering the various ways to reduce the bill faced by your beneficiaries. The tax bill is calculated at the date of death so your assets could appreciate at a faster rate than the NRB allowance over the coming years if the government estimates of the numbers likely to pay the tax by 2020/21 prove accurate.
Crucially any bill has to be paid by the executors within 6 months of your death before your loved ones can inherit, presenting them with an additional problem at an already stressful time. Some people therefore consider taking out a life insurance policy which is sufficient to settle this liability. Otherwise, your beneficiaries could be faced with liquidating the assets you had expected to leave to them.
*The changes are still draft legislation and could be amended before full implementation.
**The new permissions do not apply to final salary pension schemes.
Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you require further information with regards your own personal circumstances in relation to inheritance tax, you may wish to contact a specialist in estate planning. The information provided in this article is of a generic nature only and some of the strategies can be very complex requiring specialist advice.